Research Spotlight | Measuring Active Managers’ Value Added
July 10, 2019
The Bottom Line: Berk and van Binsbergen find that the average mutual fund generates about $3.2 million per year in value added for investors.
The Study: “Measuring Skill in the Mutual Fund Industry” by Jonathan B. Berk and Jules H. van Binsbergen. Published in the Journal of Financial Economics in October 2015.
The Process: The authors study the returns of over 6,000 actively-managed equity funds for a period of over 30 years (from January 1975 through March 2011).
They calculate the average value added for each fund by multiplying “gross abnormal return” by assets under management. The authors believe that this measure is a better assessment of managerial skill than traditional alpha. “A manager who adds a gross alpha of 1% on a $10 billion fund adds more value than a manager who adds a gross alpha of 10% on a $1 million fund,” they explain.
Gross abnormal return is computed by comparing the fund’s return against a proxy for “the investor’s alternative investment opportunity set,” namely a portfolio of Vanguard index funds with equivalent risk.
After computing average value added, the authors then sort the funds into deciles based on this measure. They perform a persistence test by counting the number of times the top decile beats the bottom decile and the number of times the top decile remains in the top half over various future time periods.
The Findings: Using this approach, Berk and van Binsbergen find that the average fund added “an economically significant $270,000 per month, or $3.2 million annually (in Y200 dollars).” They argue that they “find it hard to reconcile our findings with anything other than the existence of money management skill.”
Importantly, they find evidence that this skill is persistent. In other words, “past value can predict future value added,” for periods of up to 10 10 years.”
Even more importantly, the authors suggest that “investors appear to be able to identify talent and compensate it . . . . They detect this skill and use this information to invest their capital.” By allocating capital to funds, and thereby increasing both assets and fees earned from those assets, investors compensate managers for their skill.
The Implication: Berk and van Binsbergen’s study confirms that traditional approaches to performance evaluation do not capture the full value-added that active managers provide. In other words, it’s entirely rational that investors remain committed to active management.
The “Research Spotlight” series highlights academic papers that examine the value of active investment management and its role in investor portfolios.